1. Chapter 7 Internal Control and Cash

2. Learning Objectives
Define internal control and describe the components of internal control and control procedures
Apply internal controls to cash receipts
Apply internal controls to cash payments

3. Learning Objectives Explain and journalize petty cash transactions
Demonstrate the use of a bank account as a control device and prepare a bank reconciliation and related journal entries
Use the cash ratio to evaluate business performance

4. Learning Objective 1
Define internal control and describe the components of internal control and control procedures

5. What Is Internal Control, and How Can It Be Used to Protect a Company’s Assets?
A key responsibility of a business manager is to control operations.
Internal control is the organizational plan and all the related measures adopted by an entity to safeguard assets, encourage employees to follow company policies, promote operational efficiency, and ensure accurate and reliable accounting records.
Owners set goals, hire managers to lead the way, and hire employees to carry out the business plan. Internal control is an organizational plan and all the related measures adopted by an entity to safeguard assets, encourage employees to follow company policies, promote operational efficiency, and ensure accurate and reliable accounting records.

6. What Is Internal Control, and How Can It Be Used to Protect a Company’s Assets?
Safeguards companies assets
Encourages employees to follow company policies
Promotes operational efficiency
Ensures accurate, reliable accounting records
A company must protect its assets; otherwise, it is throwing away resources. If you fail to safeguard cash, the most liquid of assets, it will quickly slip away.
Everyone in an organization needs to work toward the same goals. It is important for a business to identify policies to help meet the company’s goals. These policies are also important for the company to ensure that all customers are treated similarly and that results can be measured effectively.
Businesses cannot afford to waste resources. Businesses work hard to make sales and do not want to waste any of the benefits. Promoting operational efficiency reduces expenses and increases profits.
Accurate, reliable accounting records are essential. Without reliable records, managers cannot tell which part of the business is profitable and which part needs improvement.

7. Internal Control and the Sarbanes-Oxley Act
U.S. Congress passed a law requiring a public company to maintain a system of internal controls.
The Sarbanes-Oxley Act (SOX) requires companies to review internal controls.
Public companies must issue an internal control report.
Internal controls are critical for public companies, so the U.S. Congress passed a law requiring public companies to maintain a system of internal controls. A public company is a company that sells its stock to the general public. Congress passed the Sarbanes-Oxley Act (SOX) to address public concern about various accounting scandals. Sarbanes-Oxley requires companies to review internal control and take responsibility for the accuracy and completeness of their financial reports. One of the SOX provisions requires companies to issue an internal control report. An internal control report is a report by management describing its responsibility for and the adequacy of internal controls over financial reporting.

8. The Components of Internal Control
Control procedures
Risk assessment
Information system
Monitoring of controls
Environment
Internal controls are monitored by internal auditors and external auditors.
A business can achieve its internal control objectives by addressing the following five components: control procedures, risk assessment, information systems, monitoring of controls, and environment. Control procedures are designed to ensure that the business’s goals are achieved. As part of the internal control system, the company’s business risk, as well as the risk concerning individual accounts, must be assessed. The higher the risk, the more controls a company must put in place to safeguard its assets and accounting records. Controls must be in place within the information system to ensure that only authorized users have access to various parts of the accounting information system. Companies hire auditors to monitor their controls. An internal auditor is an employee of the business who ensures that the company’s employees are following company policies, that the company meets all legal requirements, and that operations are running efficiently. An external auditor is an outside accountant, completely independent of the business, who evaluates the controls to ensure that the financial statements are presented fairly, in accordance with GAAP.

9. Internal Control Procedures
Competent, reliable, and ethical personnel
Assignment of responsibilities
Separation of duties
Audits
Documents
Electronic devices
e-commerce
Encryption
Firewalls
Passwords and digital signatures
Other controls
Fireproof vaults
Alarms
Job rotation
All companies need to follow internal control procedures. Employees should be competent, reliable, and ethical. Employees should also be trained to do the job, and their work should be adequately supervised.
Each employee has certain carefully defined responsibilities. The assignment of responsibilities creates job accountability, thus ensuring all important tasks get done. Smart management policies divide responsibilities between two or more people. Separation of duties limits fraud and promotes the accuracy of the accounting records. Separation of duties can be divided into two parts: separating operations from accounting and separating the custody of assets from accounting.
To assess the adequacy and accuracy of their accounting records, most companies perform both internal and external audits. Internal audits are performed by employees, while external audits are performed by independent auditors who are not employees of the company.
Documents provide the details of the business transactions and include invoices and orders, which may be paper or electronic. Documents should be prenumbered to prevent theft and inefficiency.
Encryption rearranges plain-text messages by using a mathematical process; it is the primary method of achieving security in e-commerce. A firewall is a device that enables members of a local network to access the network, while keeping nonmembers out of the network.

10. The Limitations of Internal Control—Costs and Benefits
Internal controls cannot completely prevent fraud.
Collusion is when two or more people work together to beat internal controls.
The stricter the internal controls, the higher the costs.
Internal controls are judged based upon their cost versus benefit.
Unfortunately, most internal controls can be overcome. Collusion is when two or more people work together to circumvent internal controls and defraud a company. It is difficult and costly to plan controls that can prevent collusion. The stricter the internal control system, the more it costs. How tight should the controls be? Internal controls must always be judged in light of their costs versus their benefits.

11. Learning Objective 2
Apply internal controls to cash receipts

12. Each source of cash has unique security measures.
What Are the Internal Control Procedures with Respect to Cash Receipts?
Cash receipts occur primarily when a business sells merchandise or services.
Each source of cash has unique security measures.
A receipt of cash over the counter in a store involves a point-of-sale terminal (cash register).
All cash receipts should be deposited in the bank for safekeeping shortly after the cash is received. Companies receive cash either over the counter, through the mail, or by electronic funds transfer. Each source of cash has its own security measures.
Consider a retail store. For each transaction, the retail store issues a receipt to ensure that each sale is recorded. At the end of the day, a manager proves the cash by comparing the cash in the drawer against the machine’s record of cash sales. This step helps prevent theft by the clerk.

13. Cash Receipts by Mail
Companies receive checks by mail as payments for service or merchandise.
The control cycle starts in the mail room.
Employees record the checks received and forward them to the treasurer for deposit in the bank.
A remittance advice provides information about the payment.
A lock-box system is a post office box that belongs to a bank, and the bank deposits the funds on behalf of the company.
Many companies receive checks by mail for payments of service or merchandise. Checks sent via mail are considered to be cash receipts. The control cycle for cash receipts involves several different controls. The controls start in the mail room, where a mail room employee opens the mail. The employee records the checks received and forwards them to the treasurer for deposit in the bank. A remittance advice is an optional attachment to a check that tells the business the reason for the payment.
Many companies use a lock-box system as an alternative to accepting cash or checks via the mail or over the counter. A lock-box system is a system in which customers send their checks to a post office box that belongs to a bank. A bank employee empties the box daily and records the deposits into the company’s bank account.

14. Cash Receipts by Mail
Exhibit 7-1 shows how companies control cash received by mail.

15. Learning Objective 3
Apply internal controls to cash payments

16. What Are the Internal Control Procedures with Respect to Cash Payments?
Companies make many payments by check.
Payments by check provide internal controls:
A check provides a record of the payment.
A check requires a signature by an authorized official.
Supporting evidence is reviewed prior to signing the check.
Companies make many payments by check. Companies need a good separation of duties between the operations of the business and writing checks for cash payments. Payment by check is an important internal control because a check provides a record of the payment, it must be assigned by an authorized official, and the official reviews supporting evidence prior to signing the check for payment.

17. Controls Over Payment by Check
Exhibit 7-2 shows the purchasing and payment process.
First, a purchase order is prepared and sent to the vendor. Second, the inventory is sent by the vendor to the company. At the same time, a copy of the invoice is sent to the company. When the inventory is received, it is counted and compared to the original purchase order to ensure that what was received matches what was originally ordered. A copy of the receiving report is then sent to the accounting department, where it is matched against the invoice. If the amounts match, the invoice is authorized for payment, and a check is sent to the vendor.

18. Controls Over Payment by Check
Technology streamlines payment procedures:
Evaluated Receipts Settlement (ERS) is a single-step payment approval process.
Electronic Data Interchange (EDI) is a streamlined system that communicates inventory levels between vendors and retailers.
Exhibit 7-3 shows Smart Touch Learning’s payment packet of documents, which may be in either electronic or paper format. Each of the documents in the process is prepared in multiple copies. For example, the purchase order has at least three copies. One stays in the originating department. One copy goes to the vendor. The third copy is sent to the receiving department to be matched against the packing list that comes with the delivered inventory. Only when the system is able to match all three documents (purchase order, receiving report, and invoice) is the invoice authorized for payment.

19. Learning Objective 4
Explain and journalize petty cash transactions

20. How Can a Petty Cash Fund Be Used for Internal Control Purposes?
Petty cash is used as an in-office source of cash for small immediate purchases.
It is often the responsibility of a designated employee.
A petty cash ticket serves as authorization for payment.
Uses for Petty Cash
Office donuts
Cleaning supplies
Sympathy flowers
Entertaining clients
Public transportation
Tips for service providers
It is not cost-effective for a business to write a check for taxi fare or the delivery of a package across town. To meet these needs and to streamline recordkeeping for small cash transactions, companies keep cash on hand to pay small amounts. This fund is called Petty Cash.
Petty cash controls require the following:
Designate a custodian of the petty cash fund.
Designate a small amount of cash to be kept in the petty cash fund.
Support all petty cash payments with a petty cash ticket. These tickets are sequentially numbered.

21. Setting Up the Petty Cash Fund
On August 1, Smart Touch Learning creates a petty cash fund of $200. The custodian cashes the $200 check and places the currency in the fund box.
To set up the petty cash fund, a journal entry is prepared that shows a credit to Cash and a debit to Petty Cash. A check is written and cashed at the bank. The cash is then placed in the custody of a responsible employee who must administer the fund.

22. Setting Up the Petty Cash Fund
For each petty cash payment, the custodian prepares a petty cash ticket like the one in Exhibit 7-4.
Using an imprest system is a way to account for petty cash by maintaining a constant balance in the Petty Cash account. At any time, cash plus petty cash tickets must total the amount allocated to the petty cash fund.
Maintaining the Petty Cash account at its designated balance is the nature of an imprest system.

23. Replenishing the Petty Cash Fund
On August 31, the petty cash fund holds $118 in cash and $80 in petty cash tickets. You can see that $2 is missing.
To replenish the petty cash fund, you need to bring the cash on hand up to $200. The company writes a check, payable to Petty Cash, for $82 ($200 imprest balance ‒ $118 cash on hand). The fund custodian cashes this check and puts $82 back in the fund box. Now the fund box holds $200 cash, as it should.

24. Replenishing the Petty Cash Fund
At the end of the period, the petty cash fund is replenished. A journal entry is prepared that records each of the receipts and tickets in the fund. Any unexplained cash discrepancies are recorded in an account called Cash Short & Over. A check is written for the expended amounts, and the cash is put back into the fund, returning it to its original balance.
When cash is missing, the Cash Short & Over account is used to record the unaccounted for amount.

25. Learning Objective 5
Demonstrate the use of a bank account as a control device and prepare a bank reconciliation and related journal entries

26. How Can the Bank Account Be Used as a Control Device?
Cash is the most liquid asset reported on the balance sheet.
Common bank account controls:
Signature card
Deposit ticket
Check
Maker versus payee
Routing number
Account number
Cash is the most liquid asset reported on the balance sheet because it is the medium of exchange. Because cash is easy to conceal and relatively easy to steal, businesses keep their cash in a bank account. The common controls are signature cards, deposit tickets, and checks.
A signature card is a card that shows each authorized person’s signature for a bank account. A deposit ticket is a bank form that is completed by the customer and shows the amount of each deposit. A check is a document that instructs a bank to pay the designated person or business a specified amount of money. The maker of the check is the party who issues the check. The payee is the individual or business to whom the check is paid. Each check has two parts: the routing number and account number. The routing number is the 9-digit number that identifies the bank on which the payment is drawn. The account number on a check is the number that identifies the account on which the payment is drawn.

27. How Can the Bank Account Be Used as a Control Device?
When a check is prepared, it will have a remittance advice, sometimes called a check voucher, that shows the pertinent information about the check.

28. Bank Statement
A bank statement reports the activity in a customer’s account.
It shows the account’s beginning and ending balances.
Items used to reconcile the bank account:
Canceled checks
Electronic funds transfers (EFTs)
A bank statement is a document from the bank that reports the activity in the customer’s account. It shows the bank account’s beginning and ending balances and lists the month’s cash transactions conducted through the bank account. Often the bank balance on a given date is different from the balance on the books. There are often very good explanations for the difference, such as checks that the company has written (and deducted from its books) but that have not cleared the bank. To explain the difference between the two unequal balances, a bank reconciliation is prepared. Some activities have been conducted by the business, but there is a time delay between the transaction and when the bank learns the information. These activities include deposits in transit and outstanding checks. There are also activities that happen at the bank that the business does not learn about until the business receives the periodic bank statement. These activities include amounts collected by the bank, electronic funds transfers, bank service charges, interest that is earned by the company or that is owed by the company, and nonsufficient funds checks.
A cancelled check is a physical or scanned copy of the maker’s cash (paid) checks.
Electronic funds transfer (EFT) is a system that transfers cash by electronic communication rather than by paper documents.

29. Bank Statement
Exhibit 7-6 shows the April 30, 2017, bank statement of Smart Touch Learning.

30. Bank Reconciliation
The bank reconciliation compares and explains the differences between cash on the company’s books and the bank’s records.
Differences arise because of a time lag in recording transactions, called timing differences.
A bank reconciliation is a document that explains the reasons for the differences between a depositor’s cash records and the depositor’s cash balance in its bank account. Timing differences are the differences that arise between the balance on the bank statement and the balance on the company’s books because of a time lag in recording transactions.

31. Preparing the Bank Side of the Bank Reconciliation
The bank side of the reconciliation includes:
Deposits in transit
Outstanding checks
Adjustments for bank errors
The bank side of the bank reconciliation starts with the book balance. The bank statement should be analyzed. Any amounts that the bank added to the account during the period should be added to the book balance. Any amounts that are subtracted by the bank should be subtracted from the book balance. Again, any errors in the books must be included with Part B of the reconciliation.

32. Preparing the Book Side of the Bank Reconciliation
The book side of the reconciliation includes:
Credit memorandum (bank collections)
Debit memorandum (bank payments)
Service charges
Interest revenue
Nonsufficient funds checks
Book errors
The book side contains items not yet recorded by the company on its books but that have been recorded by the bank or errors made by the company. A credit memorandum increases a bank account, while a debit memorandum is a decrease in a bank account. Nonsufficient funds (NSF) checks are checks for which the maker’s bank account has insufficient money to pay the check.

33. Completing the Bank Reconciliation
Panel A of Exhibit 7-7 lists the reconciling items, and Panel B shows the completed reconciliation. The bank balance must always add deposits in transit, subtract outstanding checks, and add or subtract corrections of bank errors. Book balances must always add bank collections, interest revenue, and EFT receipts. The book balance always subtracts service charges, NSF checks, and EFT payments and adds or subtracts corrections of book errors.

34. Journalizing Transactions from the Bank Reconciliation
Finally, a journal entry is prepared for all the adjusting items on Part B of the reconciliation. Anything added to the reconciliation will be credited. Anything subtracted from the reconciliation will be debited. There are no journal entries from the bank side of the reconciliation because we have already recorded these items in the business’s Cash account.

35. Learning Objective 6
Use the cash ratio to evaluate business performance

36. How Can the Cash Ratio Be Used to Evaluate Business Performance?
Cash is an important part of every business.
The cash ratio helps determine a company’s ability to meet its short-term obligations.
Cash equivalents are highly liquid investments that can converted into cash in three months or less.
The cash ratio is a measure of a company’s ability to pay current liabilities from cash and cash equivalents. Cash ratio = (Cash + Cash equivalents) / Total current liabilities. A cash equivalent is a highly liquid investment that can be converted into cash in three months or less.

37. How Can the Cash Ratio Be Used to Evaluate Business Performance?
Using the cash ratio formula, Green Mountain Coffee Roasters, Inc., reports a result of 0.44 and .11 during 2013 and 2012, respectively. A cash ratio above 1.0 might signify that the company has an unnecessarily large amount of cash supply. However, a very low ratio doesn’t send a strong message to investors and creditors that the company has the ability to repay its short-term debt.